Synthetics a solution to EITF 99-20?

Many investors with large portions of interest-only and credit-sensitive securitized assets, such as subordinated and equity tranches of CDOs, will be tempted to securitize these exposures via off-balance-sheet synthetic structures in the near-term, analysts said.

This is primarily because market valuations of riskier assets are expected to fall, perhaps substantially, which could make write-downs associated with Emerging Issues Task Force (EITF) 99-20 even more profound a problem for insurance company investors than prior to the fall of the World Trade Center.

Recall that EITF 99-20 requires investors to mark to market credit-sensitive portions of ABS, MBS and CDOs. To the extent that the spread blowout extends past quarter ends, managers will be looking to revalue their exposures.

"In an environment when you're going to see market values of CDOs decline, EITF is going to become even more of an issue," says Lang Gibson, head of structured credit product research at Banc of America Securities. "Presumably, though, spreads are going to eventually return to a normal level, or maybe a little outside what has been the normal level in recent months."

When values return to pre-WTC levels, under EITF 99-20, written-down assets cannot be marked back up, because the guidelines call for the lower of cost or market (LOCOM) valuation, according to analysts. However, if the portfolio managers were to restructure their exposures through derivative structures, they might not be subject to the LOCOM valuation.

It is understood that under FAS 133, managers are able to mark derivatives up as well as down. "I think we're going to see a lot of investors taking their exposure to CDOs either in synthetic note form or wrapping cash CDOs into a credit-linked note or a total-return swap," BofA's Gibson said.

As another solution, companies that own substantial portions of CDO equity might package them into a principal-protected structure. For example, a manager might pair equity with risk-free Treasurys, which could score a triple-A rating on the structure, as it guarantees principal repayment in full at maturity.

It is understood that insurance companies hold the majority of CDO equity and subordinate CDO tranches, which is one reason why so many large insurance institutions took EITF 99-20 write-downs earlier in the year.

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